If your case involves claims against your employer, or certain whistleblower claims, there is also an above-the line deduction for legal fees. That means you can deduct those legal fees on the first page of your IRS Form 1040. It is essentially like not having the lawyer fee income in the first place. But outside of employment, specific whistleblower claims, and your trade or business, be careful. You get no tax deduction at all for the legal fees, unless you are awfully creative. There are sometimes ways to circumvent these attorney fee tax rules, but you’ll need sophisticated tax help to do it, and nothing is foolproof.
What about a case that is partially taxable and partially tax-free? Remember, punitive damages and interest are always taxable, even if your injuries are 100% physical. Suppose you are injured in a car crash. Thereafter, you collect $50,000 in compensatory damages and $5 million in punitive damages. The $50,000 is tax free, but the $5 million is fully taxable. What’s more, you can’t deduct your attorney fees. If you pay a 40% contingent fee, $2 million of that $5 million goes to the lawyer, with the client netting $3 million. But the tax law says the client receives (and must report) the full $5 million.
Because the case does not arise out of employment or a trade or business, any taxable money is 100% taxable, even if 40% goes to the lawyer. This no deduction rule is catching many people by surprise. There are sometimes ways to address it, but it requires tax help, preferably before the case settles.
Here’s another example. Suppose a case settles for $2 million, and is 50% compensatory for physical injuries. The other 50% is for punitive damages or interest. There is a 40% contingent fee, and it is divided 50/50 too. That means the client nets $1.2 million in cash out of the case. But the IRS divides the $2 million case recovery in two, so the client is taxed on $1 million. And the client cannot deduct any of the $800,000 in legal fees. Sometimes, one can justify an allocation of legal fees that is not strictly pro rata, but you need to document it. And the IRS may not agree.
The same kind of attorney fee tax problems occur where there are interest payments, instead of punitive damages. You might receive a tax-free settlement or judgment, but interest is always taxable. For tax purposes, whether you collect pre-or post-judgment interest isn’t important. It is taxable, and the legal fees on that part of the case cannot be deducted. There are no easy answers to these problems, but sometimes you can improve on these dire tax results. Settlements are usually better for taxes and tax planning than judgments. And getting tax advice before a case settles is a good place to start.
Tax Reform 2.0 Should Expand Childless EITC To Reduce Poverty
House Ways & Means Committee Chair Kevin Brady (R-TX) and other top House Republicans are exploring some ideas for a proposed tax reform 2.0, building on the Tax Cuts and Jobs Act, which was enacted last year. And while they have yet to settle on the details, their framework does not include an expansion of the earned income tax credit (EITC) for workers without children at home. That’s a missed opportunity. I’ve recently finished a new analysis that shows that even a modest incre
Trump Tax Law Hurts Personal Injury Suit Settlements
Serious accident cases can produce tax-free money to clients. The injuries might be from an auto accident, slip and fall, medical malpractice, industrial accident, or drug or medical device case. If the plaintiff suffers physical injuries or physical sickness, compensatory damages should be tax free. But this tax-free treatment only apples to compensatory damages. Punitive damages and interest are taxable, and there are key changes under the Trump tax law. To qualify for tax-free treatment, the injuries must be physical. Emotional distress is not enough, and physical symptoms such as insomnia, headaches and stomachaches are normal byproducts of emotional distress, says the IRS.
Exactly what injuries are “physical” is confusing. If you make claims for emotional distress, your damages are taxable. In contrast, if you claim that the defendant caused you to become physically sick, those damages should be tax free. Yet, if it is emotional distress that causes you to become physically sick, even that physical sickness will not spell tax-free damages. However, if you are physically sick or physically injured, and your sickness or injury produces emotional distress too, those emotional distress damages should be tax free.
If you are confused, you are not alone. The chicken or egg distinction can hinge on which words you use. Plus, this area has seen major changes under the Trump tax law. If you are the plaintiff with a contingent fee lawyer, you usually will be treated (for tax purposes) as receiving 100% of the money recovered by you and your attorney. This is so even if the defendant pays your lawyer directly. If your case is fully nontaxable (say, an auto accident in which you are physically injured, where you receive only compensatory damages), that should cause no tax problems.
But if your recovery is taxable, all or in part, you could be in tax trouble. Let’s start with a fully taxable recovery, since the math there is easier to follow. Say you settle a suit for intentional infliction of emotional distress you brought against your neighbor for $100,000. Your lawyer keeps 40%, or $40,000. You might think that you would have $60,000 of income at most. Instead, you will have $100,000 of income. Up until the end of 2017, you could claim a $40,000 miscellaneous itemized tax deduction for your legal fees. You faced limitations on your deduction, but at least it was a deduction.
In 2018 and thereafter, there is no deduction for these legal fees. Yes, that means you collect 60%, but are taxed on 100%. Notably, not all lawyers’ fees face this terrible tax treatment. If the lawsuit concerns the plaintiffs’ trade or business, the legal fees are a business expense. Those legal fees can be deducted ‘above the line,’ the best kind of deduction. Mathematically, it is like not having the income in the first place.
If your case involves claims against your employer, or certain whistleblower claims, there is also an above-the line deduction for legal fees. That means you can deduct those legal fees on the first page of your IRS Form 1040. It is essentially like not having the lawyer fee income in the first place. But outside of employment, specific whistleblower claims, and your trade or business, be careful. You get no tax deduction at all for the legal fees, unless you are awfully creative. There are sometimes ways to circumvent these attorney fee tax rules, but you’ll need sophisticated tax help to do it, and nothing is foolproof.
What about a case that is partially taxable and partially tax-free? Remember, punitive damages and interest are always taxable, even if your injuries are 100% physical. Suppose you are injured in a car crash. Thereafter, you collect $50,000 in compensatory damages and $5 million in punitive damages. The $50,000 is tax free, but the $5 million is fully taxable. What’s more, you can’t deduct your attorney fees. If you pay a 40% contingent fee, $2 million of that $5 million goes to the lawyer, with the client netting $3 million. But the tax law says the client receives (and must report) the full $5 million.
Because the case does not arise out of employment or a trade or business, any taxable money is 100% taxable, even if 40% goes to the lawyer. This no deduction rule is catching many people by surprise. There are sometimes ways to address it, but it requires tax help, preferably before the case settles.
Here’s another example. Suppose a case settles for $2 million, and is 50% compensatory for physical injuries. The other 50% is for punitive damages or interest. There is a 40% contingent fee, and it is divided 50/50 too. That means the client nets $1.2 million in cash out of the case. But the IRS divides the $2 million case recovery in two, so the client is taxed on $1 million. And the client cannot deduct any of the $800,000 in legal fees. Sometimes, one can justify an allocation of legal fees that is not strictly pro rata, but you need to document it. And the IRS may not agree.
The same kind of attorney fee tax problems occur where there are interest payments, instead of punitive damages. You might receive a tax-free settlement or judgment, but interest is always taxable. For tax purposes, whether you collect pre-or post-judgment interest isn’t important. It is taxable, and the legal fees on that part of the case cannot be deducted. There are no easy answers to these problems, but sometimes you can improve on these dire tax results. Settlements are usually better for taxes and tax planning than judgments. And getting tax advice before a case settles is a good place to start.
Tax Reform 2.0 Should Expand Childless EITC To Reduce Poverty
House Ways & Means Committee Chair Kevin Brady (R-TX) and other top House Republicans are exploring some ideas for a proposed tax reform 2.0, building on the Tax Cuts and Jobs Act, which was enacted last year. And while they have yet to settle on the details, their framework does not include an expansion of the earned income tax credit (EITC) for workers without children at home. That’s a missed opportunity. I’ve recently finished a new analysis that shows that even a modest increase in the credit for these workers could substantially help reduce poverty.
The idea of increasing the EITC for workers without children at home was raised by Paul Ryan (R-WI) and former President Obama in years past. But the final Tax Cuts and Jobs Act (TCJA) excluded such a measure. In the end, the TCJA provided substantial benefits to high-income people but lower benefits to those with low- and middle-incomes.
Now that House policymakers say they once again want to revisit the tax code, they should shift their focus to those largely left out of last year’s cut and consider expanding the EITC for workers without children at home – often called “childless workers” for tax purposes. (In some cases, these individuals are parents, but their children are either living with another parent or independently.)
The existing childless EITC has at least four shortcomings, relative to the EITC for workers with children:
The credit phases in at a rate of 7.65 percent – much less than the 40 percent phase-in rate for workers with two children;
The maximum credit in 2018 is $519. In contrast, workers with two children can get a maximum credit of $5,716—more than 10 times as much;
The credit starts to phase out for single workers with no children at home once they make $8,490 (and is fully phased out once they make $15,270). Single workers with two children start seeing their credit phase out once earnings reach $18,660 and continue to receive some amount of the credit as long as their income is below $45,802. Married couples start seeing their credit phase out once they make $24,350 and remain eligible for at least some EITC until their incomes reach $51,492; and
Recipients without children must be at least 25 years old – there are no age restrictions for parents.
I analyzed an alternative that would make four major changes in the EITC for workers with no children at home. It would:
Double the phase-in rate to 15.3 percent;
Double the maximum credit to $1,038 in 2018;
Begin phasing out the credit at the same income as workers with one child; and
Allow workers as young as 21 to receive the credit.
The proposal would deliver an average benefit of $600 to workers with no children who benefit from the larger credit and lift about 700,000 adults out of poverty at a 10-year budget cost of about $95 billion. Benefits would be roughly split between people in the lowest two income quintiles.
In July, the Council of Economic Advisors (CEA) boldly pronounced that the war on poverty was “largely over”, a dubious claim explored by my colleague, Greg Acs, here. There’s still work to be done to address poverty in America – and expanding the childless EITC would be a great way to start that work.
Elaine Maag is a senior research associate at the Urban Institute - Brookings Institution Tax Policy Center.
